Long, slow recovery expected for commercial real estate in 2011

As real estate professionals prepare for a new year, many are relieved to be seeing more transactions.

David Gast, a senior vice president with CB Richard Ellis in McLean, says a recent market listing for two Class B office buildings at Tysons Corners attracted 12 showings in two weeks. “We have sent out five different proposals to prospective tenants. That’s a surprisingly strong level of interest.”

Across Virginia, the market appears to be gaining momentum. By year-end, many companies had announced expansions, and some moved into new, larger headquarters as they took advantage of the competitive pricing of a tenant’s market. Capital One Financial Corp. bought two vacant office buildings in the Innsbrook Corporate Center in Henrico County in a $17 million deal that took more than 200,000 square feet of space off the market. The credit-card and banking company, which has a corporate office park nearby, plans to expand call center and back office operations, with the expansion bringing 700 new jobs to Henrico.

Back in the Washington, D.C., area, KPMG LLP couldn’t pass up an opportunity to move into the top two floors of a nicer space. By the end of the year, the accounting firm will leave its district headquarters location of 22 years on M Street NW for a newer building on nearby K Street.

Such activity is proof that businesses are starting to feel more confident in the recovering economy. Yet, the industry doesn’t expect a sudden return of the go-go years. In its place will be what professionals are calling the “new normal,” namely slower, more cautious growth.

“While we’re seeing all the right signs that the market is starting to recover, I wouldn’t expect to see a drastic change in rental rate and vacancy over the next six months,” says Gast. “It’s going to be a long, slow recovery.”

Still, the industry seems confident that the worst is over. “We’ve seen the bottom of the cycle,” says Clark Baldwin, a senior vice president with Harvey Lindsay Commercial Real Estate in Newport News. “It will be a long climb back to what we had before, or we may never see what we saw in the run-up to the mid-2000s. But it will definitely get better.”
His firm had a strong 2010, he adds. “We’ve had a number of diverse transactions, from the sales of distressed bank-owned property to some large leases.” This year, he expects to see demand for “well-located and well-priced office, retail and industrial space.”

While the market is seeing more absorption and other positive trends, the high property valuations that produced a peak in commercial real estate prices in October 2007 are nowhere to be found. In fact, by the end of the third quarter last year, commercial real estate prices remained about 43 percent below that peak, according to Moody’s Investor Services.

This isn’t surprising after a recession in 2008 followed by two more bumpy years that saw banks shed distressed properties because developers couldn’t pay back overleveraged loans. Tenant defaults on leases became more common last year but are slowing up now. “We continued to deal with default issues and bankruptcies,” says Jay Kraft, vice president and city manager for Liberty Property Trust in Richmond, which owns a 1.1 million-square-foot portfolio in the metro area.

Some tenants weren’t able to pay their rents last year, he adds, because of a drop in business. “We try to work with these people as much as we can.” Now, Liberty is seeing a reduction in defaults, and it has cycled through many renewals where tenants wanted less space, and “they wanted to pay less money,” says Kraft. “I feel like we’ve bottomed out, and we’re going to see a gradual upswing in 2011.”
Conditions have been improving across all sectors. By the third quarter, national vacancy rates remained flat for commercial office properties at 16.8 percent, and CoStar Group Inc. reported a drop in retail vacancy from 7.4 to 7.3 percent. Meanwhile, investors have been scooping up prime properties in metro markets, and the bank-credit freeze appears to be thawing, with some banks ready to lend again for well-located projects.

Clay Culbreth, a vice president for Thalhimer in Virginia Beach, says he has spotted a trend in Hampton Roads that speaks of optimism: Smaller businesses are taking advantage of the buying climate to move out of leased space into their own buildings. “Part of that is because prices have come down and financing is so attractive that small-business owners are deciding to buy rather than lease.”

He reports a deal in the works now where a small-business owner in Hampton has offered a contract to purchase three additional office/warehouse spaces close to his headquarters. He already owns that building but currently is leasing space at other locations. “He figures: Why am I leasing space when it’s just as cheap to buy? The low interest rates are helping, too.”
Small businesses aren’t the only ones in the buying mode. Investors and institutional funds have flocked to core markets such as Washington to purchase prime properties. These metro areas are leading the recovery because the sales push down office vacancies and push up rental rates.

While metro gateway cities have been getting lots of attention, that may change soon. Executives from several major real estate investment trusts indicated during a recent real estate forum in Richmond that they are ready to invest in second- and third-tier cities, such as Richmond and Norfolk, which typically have a lower cost of doing business than large cities.

Going forward, job creation remains one of the biggest concerns in terms of a market driver. Corporate America has plenty of cash with some companies reporting record profits for the third quarter; however, many companies are waiting to see how government policy will play out on tax cuts, financial reform and other issues before hiring new employees. “Positive opportunities exist; however, our industry overall will continue to be weak until the job market improves,” Daniel M. Neidich, chairman of the national Real Estate Roundtable, said in a response to the group’s recent fourth-quarter sentiment survey.

At 6.5 percent in October, Virginia’s unemployment is well below the national rate of 9.6 percent. The state gained nearly 60,000 new jobs last year. Plus, it snagged a new corporate headquarters when defense giant Northrop Grumman decided to move its office and 300 jobs from Los Angeles to Fairfax County by this summer.

Add in the security blanket of the federal government — which is taking massive leases in Northern Virginia — and BRAC-related military relocations facing a September 2011 deadline, and it’s easy to
understand why this could be the first breakout year in a long, dry spell.

As transaction volume picks up, real estate brokers say they expect the market to tilt away from the tenant’s favor. “A lot of people are driving down the road still looking in the rear view mirror instead of looking out their windshield,” says Janet Davis, a senior vice president for Brandywine Realty Trust in Falls Church. “The deals that have just been done are at the bottom of the market.”
The deals to be done this year should reflect a market that’s trending up.

Under the “new normal,” real estate executives predict more of a focus on cost efficiencies and a continuing move to green, sustainable development. “Fundamentally we need to do more with less,” says Baldwin of Harvey Lindsay. “Employees need to be more productive. We need to get more for the money we spend.”